Here is a complete guide to US filing requirements for expats regarding dividend taxes. It will provide you with everything you need to know whether you prepare your US expat tax return yourself or hire a tax preparer in case you need professional help.
Many Americans living abroad are unaware about their US tax filing obligations and those who know often find themselves struggling to navigate through the complex tax laws. The US tax system is unusual, because it not only taxes its residents but also citizens and permanent residents living overseas. Filing from abroad becomes more complicated than filing within the US, as a new set of rules and forms applies to US expats.
What are dividends?
The IRC 26 U.S. Code § 316 (a) defines the dividends as:“ any distribution of property made by a corporation to its shareholders”. Dividends are considered as an investment type of unearned income and are treated in the same way as taxable interest and capital gain distributions.
Note: You must report all of your income, both earned and unearned regardless of where in the world it is sourced. Foreign income should be converted and reported on your US expat tax return in US dollars.
Are Foreign Dividends Taxable in the U.S.?
The answer is YES. While you reside abroad, investment income such as dividends and interest is subject to tax under the same tax rules that applied while you were living in the United States. You must report all your worldwide income on your tax return. By investing in foreign markets, you might be subjecting yourself to double double taxation, through foreign dividend taxes.
How are foreign dividends taxed for expats?
Generally, dividends are sourced where the payor is. In other words, dividend income is determined by the payor’s country of incorporation. If income is sourced in a foreign country, that foreign country has the primary right to tax the income. As such, you will pay tax on your foreign dividend income where the dividends were sourced. It’s important to know because it allows you to claim Foreign Tax Credit (FTC) on your US expat tax return. The IRS will allow you to take credit for the foreign dividend income taxes paid.
What if the foreign country does not tax dividend income?
Some countries do not impose tax on dividend income or they tax dividends at a reduced rate. If you live in Singapore or Hong Kong, you can enjoy deriving dividend income tax-free. However, the fact that the foreign dividends are tax-free in your country of residence, it does not mean you don’t have to report it on your US expat tax return.
As we mentioned before, all US persons must report all their worldwide income including the tax-free foreign sourced income they received. The income is included in your taxable income and taxed at your progressive tax rate on your US tax return.
If you paid tax on your foreign dividend income, you can claim foreign tax credit for the taxes paid on that income.
Foreign dividends and tax treaties
The U.S. has signed over 65 tax treaties around the world aiming to reduce or eliminate the issue of double taxation completely. Each tax treaty is different depending on the country the U.S. signed the agreement with. However, many of the income tax treaties to which the IS is a party can allow you to be charged a reduced withholding rate on dividends.
Some of the dividend tax treaties permit US persons (who are taxed on their worldwide income by the US and its host country) to take advantage of a lower statutory rate for dividends. The dividend income might be resourced by a treaty as well. Sourcing rules can be complicated and subject to many exemptions within the tax treaties. Some of these exemptions are listed here.
You might want to seek the advice of a tax professional to navigate through the complexities of the tax income treaties and the IRC to lessen your overall global tax burden. Our friendly team of IRS Enrolled Agents specializes in expatriate tax issues and you can book a free call with one of our tax expert.
Are foreign dividends qualified dividends?
Dividends can be classified as ordinary or qualified. While ordinary dividends are taxed as ordinary income, qualified dividends benefit from favorable tax treatment and are taxed lower at capital gain tax rates. In order for a foreign dividend be classified as a qualified dividends, the foreign corporation must meet any of the following requirements:
- The corporation paying out the dividends is eligible for benefits of a comprehensive income tax treaty with the United States that includes an exchange of information. You can read more about it here.
- The corporation is incorporated in a U.S. possession.
- If the corporation doesn’t meet neither requirement (1), nor (2), but the stock for which the foreign dividends were paid out is traded in the United States securities markets.
In a nutshell, most larger companies and publicly traded companies will meet the IRS requirements of a foreign qualified corporation and the dividends paid out will satisfy the definition of “qualified” dividends under the US tax law. You will be eligible for a reduced tax rate on these. It means that these foreign dividends will be reported as qualified dividends on your expat tax return.
How much in dividends can you have before paying tax?
It depends on whether or not you have any other income. If your only income is investment income, you must file a return once you receive more than $1,050 of investment income. This amount will be tax-free. Moreover, if you additionally have earned income, but your total income does not exceed the standard deduction ($12,400 in 2021), or the entire dividends income does not exceed the standard deduction, no tax is due.
How do you avoid paying taxes on foreign dividends?
The foreign tax credit is the best tool that allows you to eliminate your US tax liability on your foreign dividend income. It allows you to claim a dollar to dollar amount of US tax credit for the amount of foreign tax you paid on your foreign dividends. Hence, if you paid foreign dividend tax in the host country, you can claim it on your US expat tax return bringing your tax liability to zero.
Related: If you’d like to learn more about form 1116 and how to complete it, check out this article.
As we mentioned before, if your income is below the standard deduction, all your taxable income will be tax-free. Of course, many expats have primarily earned income, not investment income. Let’s take a look at real life examples of US expats successfully taking advantage of the tools available to them to reduce or bring their tax owing to zero.
Example 1. Amy is a school teacher in Dubai and she makes $80,000 annually. She received foreign dividend income of $12,000. The United Arab Emirates does not levy income tax on individuals nor has signed a tax treaty with the US. The dividends are classified as ordinary dividends and Amy cannot use the foreign tax credit to offset her US tax bill.
The best solution for Amy is to claim the foreign earned income exclusion on her foreign earned income and use the standard deduction to bring her taxable income to zero.
Note: FEIE comes with certain disadvantages and this scenario might not be the best solution for your particular situation. Consult a professional when in doubt.
What would happen if Amy received $20,000 of dividend income?
The standard deduction will only exclude $12,400. The remaining $7,600 of dividend income would be taxed at ordinary rates of 10%. Amy’s US tax liability would be $760.
Example 2. John is a financial advisor in London. He earns $103,000 annually and in 2021 he received $10,000 of dividends from a UK corporation. Since the dividends are sourced in the UK, they will be subject to the UK taxation as well as John’s salary. John will be able to claim foreign tax credit for the amount of foreign dividend tax he paid on his investment income. He can choose to use the FTC or the FEIE to exclude his foreign earned income.
Tax tip 1
Foreign Earned Income Exclusion can only exclude foreign and earned income. Dividends are a type of unearned income. It cannot be excluded using the FEIE. You can only use the FTC to minimize your tax burden.
Net Investment Income Tax (NIIT)
If you are an investor, you might also be subject to net investment income tax of 3.8%. NIIT applies to high earners with a substantial amount of investment income. Net investment income includes interest, dividends, capital gains, rents and royalties regardless of where the income is sourced. The NIIT applies to US expats and you cannot offset it using the foreign tax credit. This tax is triggered when your modified adjusted gross income exceeds a certain threshold.
The threshold amount for married filing jointly is $250,000 while for married filing separately is $125,000. Taxpayers filing under Single filing status do not trigger the NIIT tax until their MAGI exceeds $200,000.
How to calculate net investment income tax?
Net investment income tax is surtax on the top of your income tax once your income exceeds the mentioned above thresholds.
Step 1. Calculate all your investment income subtracting any related expenses.
Step 2. You must calculate your Modified Adjusted Gross Income (MAGI). Some tax-exempt interest payments and certain deductions might need to be added back. NIIT often surprises US expats as in order to calculate MAGI, adjustments must be made for certain foreign income and/or deductions.
Step 3. Fun part – Calculating NIIT! If you think you can simply multiply the net investment income by 3.8%, you are wrong. The IRS made this calculation a little more complicated. You must determine which amount is lesser – net investment income or the amount your MAGI exceeds the NIIT threshold. Once you establish this, then you multiply this amount by 3.8%.
Example 3. Remember John who lives in London? He is filing under the Single filing threshold. For the purpose of this example, John earns $250,000 annually and receives $20,000. His MAGI exceeds the NIIT threshold by $50,000. The net investment income is $20,000 which is less than $50,000. The NIIT will be calculated by multiplying the net investment income by 3.8%. John will have to pay $760 for NIIT.
Tax treatment of foreign dividends isn’t always straightforward which makes preparing your US expat tax return a little more complicated. We hope that this article gives you a better overview of how your foreign investment income is taxed and gives you insights on how to reduce your foreign dividend tax liability. When in doubt, consult a professional.